2015-Issue 7— In four related cases (the partners were all general partners in the same partnership, and the cases were stipulated to and decided together), the Tax Court was faced with deciding whether general partners who personally guarantee the debt of a partnership and were not in bankruptcy themselves could otherwise exclude cancellation of debt income resulting from the partnership’s bankruptcy. The Tax Court held in each case that the partners could exclude the cancellation of debt income under Section 108(a)(1)(A). The cases are Gracia v. Commissioner, T.C. Memo 2004-147, Mirarchi v. Commissioner, T.C. Memo 2004-148, Price v. Commissioner, T.C. Memo 2004-149 and Estate of Martinez v. Commissioner, T.C. Memo 2004-150. As expected, the IRS issued its notice of non-acquiescence on February 9, 2015, in all of the four cases (IRB No. 2015-6) and will apparently continue to litigate the issue regardless of these decisions.
The four cases are the same factually and legally. Each of the partners was a general partner in the partnership. Each of the partners had personally guaranteed the partnership debts. The partnership initiated the bankruptcy case under title 11 of the United State Code (Bankruptcy). During the pendency of the bankruptcy, the partnership and partners reached an agreement with the U.S. Trustee under which the partners would make payments to the partnership in exchange for a full release of all claims against them including any claim by the creditors under the guarantees. The bankruptcy court approved the agreement and discharged and released the partners from all liability related to the partnership including their personal guarantees of the partnership debt. The order signed by the Bankruptcy Court provided that each partner was “subject to the jurisdiction of the Bankruptcy Court.” The partners excluded the cancellation of debt income (CODI) on their returns, and the IRS issued a notice of deficiency for the same.
Tax Court Holding
The Tax Court held that the individual partners could exclude the CODI from gross income under Section 108(a)(1)(A) because the partnership debt was discharged in a title 11 case within the meaning of Section 108(d)(2). The Tax Court also noted that the Bankruptcy Court’s order discharged and released the partners from liability in a title 11 case and explicitly asserted jurisdiction over them.
IRS Weighs in
On February 9, 2015, the IRS published in the Internal Revenue Bulletin (IRB 2015-6) its notice of non-acquiescence in the four cases. The IRS mentioned the legislative history behind Section 108 and said, “Congress indicated its intent to limit the scope of section 108(a)(1) to bankrupt or insolvent partners, and not to all partners of a bankrupt partnership.” For that reason, the statute requires partners of a bankrupt partnership to assess their ability to apply Section 108 by looking at their particular facts and circumstances (Section 108(d)(6)). The IRS feels the Tax Court’s ruling is inconsistent with the structure of Section 108 — requiring the taxpayer seeking to exclude the CODI to be a “debtor” in a title 11 case or insolvent at the time of the discharge. The IRS noted that the individual taxpayers were not “debtors” under a title 11 case and, as such, did not need the “fresh start” that Section 108 can provide to a debtor in bankruptcy.
As convenient as it was to disagree with these holdings, noting that the individuals were not debtors in a title 11 case, the statute does not seem to support the IRS’s litigation position. The statute does not limit the exclusion to situations where the partnership and the partner are both “debtors” in a title 11 case. Instead, the limitation requires that the exclusion be examined at the partner level. If the partner receives an allocation of CODI, the partner may exclude the CODI from income if the discharge occurs in title 11 case or the discharge occurs when the taxpayer is insolvent. The provision requiring that the discharge occur in a title 11 case does not require that the partner actually be a “debtor” in a title 11 case. It requires that the discharge occur in the title 11 case. Congress could easily have written the partnership application provisions differently if it had actually intended to limit the exclusion to situations where partners were “debtors” in a title 11 case, but that is not what it did. Instead, as mentioned before, the statute simply requires each partner to apply the Section 108 exclusion to their own facts and circumstances without regard to the partnership.
In this particular situation, the partnership was in a title 11 case. The partnership debt was discharged in a title 11 case. The partners were under the jurisdiction of the Bankruptcy Court when the discharge occurred, and the partners were specifically discharged under their guarantees. The Section 108(a)(1)(A) exclusion does not require the taxpayer to be a “debtor” as the IRS asserts in its February 9 Action on Decision; it merely requires that the discharge occur in a title 11 case.
Alvarez & Marsal Taxand Says:
The debate over whether a partner needs to be a debtor in a title 11 case instead of simply receiving a discharge while under the jurisdiction of the Bankruptcy Court will likely continue. The facts presented in these four cases are not unusual with many partnership business ventures. As the economy continues to change and present unforeseen outcomes, many of these partnerships will find themselves restructuring their finances and even having to file for bankruptcy. Many lenders to these flow-through entities have the individual partners co-sign on partnership debt, making them personally liable in the event the partnership is unable to pay. With personal liability on the line, it appears that the Tax Court can be persuaded that a partner can take advantage of Section 108(a)(1)(A) as long as the Bankruptcy Court has jurisdiction over the partner and the discharge occurs during the pendency of the case or pursuant to the plan of confirmation. Flow-through entities present many unusual issues in restructuring and bankruptcy. Bankruptcy Courts have broad jurisdictional reach and can have authority over debtors and non-debtors alike in implementing a plan of confirmation in bankruptcy proceedings. Alvarez & Marsal Taxand has experience in representing the entities and owners in and out of formal bankruptcy proceedings and can help you avoid pitfalls.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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